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The Limitations Of No-Arbitrage Arguments For Real Options

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  • F. HUBALEK

    (Department of Statistics, Probability Theory and Actuarial Mathematics (107/5), Vienna University of Technology, Wiedner Hauptstr. 8–10, A–1040 Wien, Austria)

  • W. SCHACHERMAYER

    (Department of Statistics, Probability Theory and Actuarial Mathematics (107/5), Vienna University of Technology, Wiedner Hauptstr. 8–10, A–1040 Wien, Austria)

Abstract

We consider an optioncwhich is contingent on an underlying$\tilde S$that is not a traded asset. This situation typically arises in the context of real options. We investigate the situation when there is a "surrogate" traded assetSwhose price process is highly correlated with that of$\tilde S$. An illustration would be the cases whereSand$\tilde S$model two different brands of crude oil. The main result of the paper shows that in this case one cannot draw any non-trivial conclusions on the price of the option by only using no-arbitrage arguments.In a second step we try to isolate hedging strategies on the traded assetSwhich minimize the variance of the hedging error. We show in particular, that the naive strategy of simply replacing$\tilde SbySfails to be optimal and we are able to quantify how far it is from being optimal.

Suggested Citation

  • F. Hubalek & W. Schachermayer, 2001. "The Limitations Of No-Arbitrage Arguments For Real Options," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 4(02), pages 361-373.
    • Handle: RePEc:wsi:ijtafx:v:04:y:2001:i:02:n:s0219024901001024
    DOI: 10.1142/S0219024901001024
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    Cited by:

    1. Lin Zhao & Sweder van Wijnbergen, 2013. "A Real Option Perspective on Valuing Gas Fields," Tinbergen Institute Discussion Papers 13-126/VI/DSF60, Tinbergen Institute.
    2. Josef Schosser, 2020. "Real Option Exercise Decisions in Information Technology Investments: a Comment," SN Operations Research Forum, Springer, vol. 1(4), pages 1-7, December.
    3. Edgardo Brigatti & Felipe Macias & Max O. Souza & Jorge P. Zubelli, 2015. "A Hedged Monte Carlo Approach to Real Option Pricing," Papers 1509.03577, arXiv.org.
    4. Arnold, Jan & Minner, Stefan, 2011. "Financial and operational instruments for commodity procurement in quantity competition," International Journal of Production Economics, Elsevier, vol. 131(1), pages 96-106, May.
    5. Marcel Philipp Müller & Sebastian Stöckl & Steffen Zimmermann & Bernd Heinrich, 2016. "Decision Support for IT Investment Projects," Business & Information Systems Engineering: The International Journal of WIRTSCHAFTSINFORMATIK, Springer;Gesellschaft für Informatik e.V. (GI), vol. 58(6), pages 381-396, December.
    6. Philipp N. Baecker, 2007. "Real Options and Intellectual Property," Lecture Notes in Economics and Mathematical Systems, Springer, number 978-3-540-48264-2, December.
    7. Henderson, Vicky & Hobson, David G., 2002. "Real options with constant relative risk aversion," Journal of Economic Dynamics and Control, Elsevier, vol. 27(2), pages 329-355, December.

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